Bitcoin: Is It A Bubble?

A bubble is created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior.

Warren Buffett recently noted:“You can’t value bitcoin because it’s not a value-producing asset.” He added that there’s no telling how far bitcoin’s price will go and described it as a “real bubble in that sort of thing.”

The value of bitcoin is tied to the aggregate value of transactions using bitcoin, which is the transaction (means of payment) demand for bitcoin. The transaction demand, Q, is simply P*T, where P is the price of bitcoin, and T is transaction volume in circulation. The transaction demand provides an anchor for the price. The other source of demand for bitcoin is investment demand which includes speculative demand and store of value. As a store of value, bitcoin is a safe haven like gold, a so-called digital gold. Furthermore, bitcoin’s utility as a store of value is dependent on its utility as a means of payment, Kellher explained it succinctly, “if bitcoin does not achieve success as a medium of exchange, it will have no practical utility and thus no intrinsic value and won’t be appealing as a store of value”. Simply put, if there is no transaction demand, then there is no store of value demand.

We will argue that bitcoin is not a suitable means of payment for ordinary consumer or business or government transactions; it is rather well suited for the means of payment in the underground economy. Then we will discuss the Chinese demand for bitcoins which averaged daily volume of 2 billion dollars in 2016, and its aftermath.

The Coinage Act of 1965 states: “United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues.” This statute means that all United States money as identified above are a valid and legal offer of payment for debts when tendered to a creditor. There is, however, no federal statute mandating that a private business, a person or an organization must accept currency or coins as payment for goods and/or service (excerpt from an FAQ on Treasury site).

The fact that fiat currency is accepted as payment is not because there is a mandate to accept it, but because there is a demand for legal tender (for payment of taxes and debt). As of this writing, bitcoin and other cryptocurrencies do not have legal tender status in any jurisdiction.

It should not be a surprise that the US Internal Revenue Service (IRS) in a 2014 guidance states:

“Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency. Bitcoin is one example of a convertible virtual currency. Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies”

The said IRS guidance also states that for federal tax purposes, virtual currency is treated as property which means they’re subject to capital gains taxes. The following excerpt from Money magazineis a good explanation:

… imagine you bought a $3,500 bedroom set at Overstock.com using half a bitcoin (or 50 million “satoshis”) that you purchased for $200 at the start of 2016. That represents a capital gain of $3,300. At the typical 15% long-term capital gains rate, that works out to a $495 tax hit.

Of course, if you spend appreciated bitcoin that you’ve held for less than a year, that would be considered a short-term gain, taxed at ordinary income tax rates that can run as high as 39.6%.

You’re technically required to list every purchase you made in any given year with bitcoins, outlining the capital gain or loss from selling the digital currency to make the transaction, “no matter how small,” ….

The armor of pseudo anonymity of bitcoin is ruptured. Recently, a California federal court ruled in favor of the IRS in a case against Coinbase, ruling that the cryptocurrency exchange must release personal information — including names, birth dates, addresses, taxpayer IDs and other records — of more than 14,000 users who handled at least $20,000 in digital assets in 2017. Don’t forget that it was the IRS that nailed Al Capone.

In 2015, the Commodities Futures Trading Commission (CFTC), which has oversight over futures, options, and derivatives, ruled that bitcoin and other virtual currencies are commodities. CFTC announced recently that it would allow the CME and CBOE to launch bitcoin futures trading, a major milestone for bitcoin. As of this writing, LedgerX and CBOE started trading bitcoin options and futures and CME plans to launch bitcoin futures on Dec. 18, 2017.

In short, bitcoin is an asset and not a currency! Labeling it as cryptocurrency or virtual currency is adding to the confusion, in our opinion labeling them “crypto token” may be better, but we will continue to use the conventional label. Anyway back to why bitcoin is not a suitable means of payment for ground economy.

When bitcoin prices are rising and expectation of price increase is high, people would hoard the bitcoins rather than spend it. Would you pay for the vacation you booked on Expedia (one of the sites that accepts bitcoin) if you expect the prices to double every two or three months? And when prices are declining, they would dump the bitcoins like there is no tomorrow. Would merchants continue to accept it when prices are falling like a rock? In a rising environment, it is not reasonable to pay for your ordinary purchases with bitcoins, and in a falling environment, it is not reasonable to accept bitcoins for purchases. A means of payment for ordinary consumer use needs to be stable and not volatile. Additionally, bitcoin transaction processing is about 3 to 4 transactions per second (tps) which is slow compared with PayPal (NASDAQ:PYPL) (193 tps) and Visa (NYSE:V) (1667 tps), and it can take up to ten minutes for the distributed “ledger” to be updated and for a transaction to be final. Another issue is the skyrocketing bitcoin transaction fees during heavy traffic (more than 3.3 tps); since November the average fee has been above $5, and on December 12, the average fee hit $26. For the above reasons, it does not seem that bitcoin is suitable for ordinary consumer or business or government use.

Another source of transaction demand for bitcoin is from the underground economy (loosely, transactions that are not legit). You don’t need to carry a wad of cash across town or state or country or continent to conduct an underground transaction. Cash from illegal activities can now be parked in bitcoin wallets. Bitcoin and cryptocurrencies have (almost) enabled national and international payment network for the underground economy. You can transfer cryptocurrencies from one account to another without problem, and up to recently, you could monetize them at exchanges without being reported to IRS. The recent regulation will create problems for the underground economy that would require bypassing exchanges.

Legal cannabis was a $6 billion industry last year and is expected to grow to $50 billion by 2026. Pot is legal for both recreational and medical use in California, Oregon, Washington, Nevada, Colorado, Massachusetts, Maine, Alaska and the District of Columbia, and approved in 20 additional states for medical purposes only. But because pot is illegal under federal law, big banks and credit card companies steer clear. That’s forced most merchants to accept cash only, a logistical headache and constant security threat. Bloomberg reports that Bitcoin Is Helping the Pot Business Get Over Its Banking Problem.

In 2015 and 2016, the overwhelming majority of bitcoin trading was conducted through China-based exchanges and with yuan. According to data from Bitcoinity, over 90 percent of trading volumes throughout 2016 were in exchange for yuan. As the PBOC tightened capital controls and the yuan continued to weaken, bitcoin became an increasingly attractive way for Chinese residents to get their money out of the country. An examination of daily bitcoin trading volumes provides prima facie evidence that this may have been the case between late 2015 and late 2016. So, it seems conceivable that the roughly 250 percent rise in the dollar price of bitcoin between January of 2015 and January of 2017 was due at least in part to Chinese capital outflows (for detail see blog post by Brad Setser on CFR).

To recap, in 2015 and 2016, over 90% of bitcoin trading was in China. Chinese demand for bitcoins to send their money out of the country was a contributor to the 250 percent rise in the price.

In January 2017, Chinese authorities stepped up scrutiny of bitcoin exchanges in the country. In September 2017, the Chinese regulators banned crypto trading on domestic exchanges, following a Sept. 4 notice issued by the Chinese central bank that banned “initial coin offerings.”

The bitcoin trading volume on all exchanges for December 2015 through November 2017 is tabulated in Table-1 in the Appendix. As it can be seen, the volume dropped from average 3M per day in 2016 to average 150K since February 2017, a reduction by a factor of 20.

You would expect reduction of trading volume on exchanges by a factor of 20 to reduce the price. Wrong! The price has shot up by almost a factor of 20 since January 2017! On Dec. 12, bitcoin hit a record high of $17,428, a roughly 20-fold increase in its price for the year.

Please note that data in Table-1 is trading volume on all exchanges, it does not include trading outside the exchanges. We need to analyze the blockchain to obtain total daily volume and then we can figure out the dark pool. If someone has the data or a cryptocurrency programmer is interested to analyze the blockchain, please contact me.

It seems the dynamics driving the price of bitcoin changed fundamentally in the first few months of 2017. What is the dynamics that causes the price to increase 20 folds when volume is reduced by a factor of 20? Is it speculative demand? Or transaction demand? Or systematic manipulation?

In December 2016 and January 2017, daily bitcoin transaction demand in Chinese exchanges was averaging 4 billion dollars, twice the daily average in 2016. It doesn’t seem that anything else has replaced the Chinese demand for bitcoin. We need a large transaction demand to anchor the price. Until we see the transaction demand, we have to assume price is unhinged from fundamentals.

In an interview with Bloomberg, Nobel Prize-winning economist Joseph Stiglitz said “bitcoin is successful only because of its potential for circumvention, lack of oversight.” He added: “So it seems to me it ought to be outlawed. It doesn’t serve any socially useful function.” And concluded with “If the government says ‘the reason bitcoin is being used is this circumvention,’ they could clamp down any moment, and then it collapses.”

With the exception of Chinese clamping down on bitcoin, we do not see a serious effort to clamp down on the circumvention.

Until the governments clamp down on bitcoin and cryptocurrency circumvention (which doesn’t look likely at this point), expect wild fluctuations in the cryptocurrency prices.